Tax Court: Transfers to Liquidating Trusts Did Not Result in Deductible Losses

(Parker Tax Publishing June 2020)

The Tax Court held that a taxpayer who transferred parcels of real property to liquidating trusts for the benefit of the mortgage holders was not allowed to deduct a loss on the properties in the year of the transfers. The Tax Court held that, because the proceeds from the sales of the properties in later years were applied to discharge the taxpayer's liabilities, the taxpayer was the owner of the liquidating trusts during those later years under Code Sec. 677(a) and the trusts therefore were not separate taxable entities; therefore, the transfers did not accomplish bona fide dispositions evidenced by closed and completed transactions under Reg. Sec. 1.165-1(b). Sage v. Comm'r, 154 T.C. No. 12 (2020).

Background

Jason Sage, a real estate developer, owned Integrity Development Group, Inc. (IDG), an S corporation. By 2007, IDG had acquired three parcels of real property outside Portland, Oregon: (1) the Village at Summer Creek (Village), (2) the North Plains Sunset Terrace (Plains), and (3) Gales Creek (Creek). IDG owned Creek through Gales Creek Terrace LLC (GCT), a single member LLC that elected to be treated as a disregarded entity for federal tax purposes. IDG took out loans totaling over $11 million from Sterling Savings Bank (Sterling) which were secured by Village and Plains. GCT took out a line of credit from Community Financial Corp. (CFC) secured by Creek.

Sage's real estate business was hit hard by the national economic downturn and by late 2009 Village, Plains, and Creek were worth significantly less than the liabilities they secured. Sage therefore decided to transfer those parcels into liquidating trusts, which he believed would protect his creditors' interests in the case of an involuntary bankruptcy. He did not consult with either Sterling or CFC before doing so.

To accomplish the transfers, IDG first organized three so-called "project LLCs," one for each property. Each project LLC had IDG as its sole member and elected to be disregarded for federal tax purposes. IDG transferred Village and Plains to the correspondingly named project LLCs for no consideration, and GCT made a similar transfer of Creek. The deeds were recorded on December 31, 2009. That day, Sage established three trusts under Oregon law to house the newly created project LLCs, and notified Sterling and CFC that he had established these trusts. The trust instruments designated Sterling as the beneficiary of the trusts corresponding to the Village and Plains properties and CFC as the beneficiary of the trust corresponding to the Creek property.

Despite the ownership changes, IDG and GCT remained liable to Sterling and CFC under the respective loans. In applying for an exemption from a county transfer tax relating to Village, Sage stated that the property was "not being sold, but simply transferred to another wholly owned entity" with "no transfer of debt" in order to "create a liability protection entity." Sage and his companies continued to manage and market Village, Plains, and Creek. Village was sold in 2010 and Plains was sold in 2012; the net proceeds from these sales were distributed to Sterling, which in turn credited them against IDG's outstanding loans. With respect to Creek, Sage and CFC reached an agreement in 2011 under which Creek was transferred to CFC in exchange for the settlement of GCT's debt.

On its 2009 tax return, IDG reported ordinary losses stemming from the transfers of Village, Plains, and Creek to the trusts totaling over $8 million. The losses flowed through to Sage under Code Sec. 1366, and he claimed them on his 2009 tax return. The IRS disallowed the losses and issued notices of deficiency, which Sage challenged in the Tax Court.

Code Sec. 165(a) permits a deduction for any loss sustained during the tax year and not compensated for by insurance or otherwise. To be deductible, Reg. Sec. 1.165-1(b) requires that the loss be evidenced by closed and completed transactions, fixed by identifiable events, and actually sustained during the tax year. Only a bona fide loss is allowable. Under Code Sec. 671, if the grantor of a trust is treated as the owner of the trust or any portion of it, the grantor must take into account those income items, deductions, and credits attributable to the trust or portion of the trust he or she is treated as owning. Code Sec. 677(a)(1) considers a grantor to be the owner of any portion of a trust whose income, without the approval or consent of any adverse party, is, or may be, distributed to the grantor. Reg. Sec. 1.677(a)-1(d) specifies that Code Sec. 677(a) applies to the portion of a trust whose income may be applied in discharge of a legal obligation of the grantor.

Sage argued that IDG was entitled to a deduction in 2009 because the transfers of the properties to the trusts for the benefit of the lenders were bona fide dispositions of property that generated actual losses. According to Sage, the creation of the trusts implicitly involved two steps: (1) the transfer of property from IDG to Sterling or CFC, and (2) the transfer of property from Sterling or CFC to the respective trust. Sage asserted that step one was tantamount to a sale, and IDG should be able to recognize a loss equal to the difference between IDG's basis in the respective piece of property and its fair market value.

In making his argument, Sage cited Chief Counsel Advisory (CCA) 200149006, which deals with a proposed chapter 11 bankruptcy plan and states that liquidating trusts are generally taxed as grantor trusts with the creditors treated as the grantors and deemed owners. According to the CCA, the debtor is treated as having transferred assets to the creditors in exchange for relief from the debtor's indebtedness to them. The creditors are then treated as then transferring those assets to the trust for the purposes of liquidation. Sage also cited Rev. Rul. 72-137 and other similar rulings involving a corporation enacting a plan of complete liquidation that requires the distribution of all assets within 12 months, and with the consent of shareholders, places certain assets not readily disposed into liquidating trusts for the shareholders' benefit. In these rulings, the IRS concluded that such assets complied with the requirement of divestment within 12 months because the shareholders had essentially received the assets that were transferred to the trusts. Sage further argued that Sterling and CFC were grantors because under Reg. Sec. 1.671-2(e)(3), a grantor includes any person who acquires an interest in a liquidating trust from a grantor. According to Sage, Sterling and CFC acquired interests in the trusts by virtue of being named beneficiaries, and thus were grantors.

Analysis

The Tax Court rejected Sage's arguments and held that under Reg. Sec. 1.671-2(c)(1), IDG and GCT were grantors of the respective trusts by virtue of their direct gratuitous transfers of ownership of the project LLCs to the trusts. The court found that, as the corpus of each trust was used to satisfy the legal obligations of IDG or GCT, they were the owners of the respective trusts after 2009, and the trusts therefore were not separate taxable entities under Reg. Sec. 1.677(a)-1(d). According to the court, the transfers did not accomplish the bona fide dispositions of the properties, evidenced by closed and completed transactions, necessary to support the losses ultimately reported by IDG and passed on to Sage.

The court found no support for Sage's argument that the transfers to the trusts were tantamount to a sale. The court said that neither the Code nor the regulations offer any hint that liquidating trusts incorporate an implicit two-step structure or that they provide a safe harbor from the normal operation of the grantor trust rules. The court also found that, even if CCA 200149006 could be cited as precedent, it didn't apply because neither Sterling nor CFC were aware of the creation of the liquidating trusts and did not agree to relieve IDG or GCT of their indebtedness in exchange for the assets that were transferred to the liquidating trusts. Likewise, the court found that the revenue rulings Sage cited did not help his case because Sage's unilateral transactions did not resemble the factual situations addressed in the rulings. Finally, the court was unconvinced that Sterling and CFC were grantors by virtue of being beneficiaries of the trusts. The court found no support for that argument and said that, if Sage were correct, every beneficiary of a liquidating trust would automatically be a grantor, with the tax repercussions that follow. In the court's view, if the regulations intended such a sea change, they would say so directly.

For a discussion of the requirements for deducting a loss not compensated by insurance or otherwise, see Parker Tax ¶114,510. For a discussion of the taxation of grantor trusts, see Parker Tax ¶56,105.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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